The Noble Pundit

Why The Democrats Hate Greenspan

From FOXNews: Greenspan Urges Social Security Cuts

The Democratic candidates, of course, went nuts.

Kerry: "If I'm president, we're simply not going to do it."

Edwards: "an outrage."

Kucinich (as if he really matters): "a disgrace."

So what would cause such a violent reaction? The absolute bugaboo of the liberal Democrats: responsibility.

Social Security is too great a burden on our future economy to continue in its current form. It is a generally accepted fact by both sides of the debate that something must change. Either taxes will go up or benefits will go down (or there will be a complete transformation of the program, but that seems unlikely at this juncture).

Greenspan is correct in that the government has made promises that it does not have the funding to cover. Greenspan is also correct in suggesting that the tax cuts are beneficial in trying to promote a healthy economy.

In short, Greenspan has suggested that the government should act responsibly, providing for an atmosphere conducive to growth and at least making a pretense of balancing the budget. But to suggest that the government should act responsibly is in absolute contrast to the entitlements crowd. They believe that the entitlements are sacred cows and need to be paid for by additional taxation - even at the expense of ending up on the backside of the Laffer Curve. So Social Security, in its current form, is an untouchable - which means that taxes must be raised.

The Democrats aren't upset that Greenspan pointed out the SS is broken. Rather they are upset because he pointed out their plan of action with an unremarkable clarity in the consequences of their action. They fear that the public will turn against them if they knew the truth. So they have to resort to attacking the messenger.

Jobless Claims Down

The Labor Department is reporting that for the week ending Feb.14 new jobless claims dropped significantly, posting their largest decline since November.

Now I'm not going to sit here this morning and analyze how this might fit into the overall ecnomic environment. There are enough other blogs, along with CNBC, MSNBC, FOXNews, CNN, and the major networks who will be doing that. Instead I'm going to take a different approach.

Let me begin by stating that I believe that the job market is starting to improve - just a little bit. Many of my longtime readers may recall that back around July of last year I started looking for a new job. It wasn't until Mid-November that I was able to find anything that was a step up. It essentially took me nearly 5 moths to find a new job - and I was employed at the time, which supposedly makes it easier to get a new job.

Now since November, I've received another job offer, for significantly more money and better benefits, and was felt out about yet another. Since last July, I have gone from being extraordinarily unlucky to extraordinarily lucky. Nothing has really changed in my approach (although I have not actively sought a new job since November). But something has begun to change in the job market.

I think that right now what we're beginning to see is a move towards bringing in new people in the revenue producing segments of businesses. Salespeople, manufacturing people, and customer service positions all seem to be in a little bit of demand right now.

This is great and wonderful, but most of the unemployed at the moment seem to be from support positions, IT particularly. Those types of positions are not being created just yet. So support staff candidates are going without offers.

Now some will argue that the job that are being created now are the low eage positions. And that, by and large, is true. But in order for there to be a need for support staff, there needs to be a staff to support.

I think that a lot of companies learned a very tough lesson back in the late '90s. The last brokerage firm I worked for went on a hiring spree from 1996-1999 and more than quadrupled the size of the company - and then from 2001-2003 they let go basically everyone they hired, plus some. It was a painful lesson for them. And I think that right now, there are a number of companies that are trying to take too much away from that experience. In an effort to make sure they won't have to let people go, they are foregoing revenue and profits to avoid hiring people.

In the late '90s the hiring pendulum was at one extreme, where anybody could get a job in very short order, regardless of anything. In the last 2 or 3 years, we've been at the other extreme, where very few could get a job, no matter how well qualified they might be. At both extremes, the job market was operating very inefficiently and companies have paid a price, either in realized layoffs or unrealized profits.

My sense, and I have nothing really to back it up with it is just a gut feeling, is that things are starting to return to a more normal state. It should be interesting to see how long it takes for hiring to really return to normal.

Pro-Market Vs. Pro-Business

Via the Flemish Beerdrinker

Bruce Bartlett over at Townhall.com has written an excellent article that points out that the normal conservative reflex of pro-business is not always pro-market. As similar as the two terms sound, they are not the same. In fact, many times they end up opposed to each other.

Now Ivan over at the Flemish Beerdrinker does a pretty good job of looking at the relationship between pro-business and pro-market over the last decade (I don't appear to be able to link directly to the article so look for the one datestamped 14/02/2004 - 14:42:13 and titled: Is being pro-market conservative?).

I believe that the lessons of pro-market vs. pro-business can be best illustrated by one of my favorite industries - the airline industry.

From it's earlier beginnings the airline industry was largely unregulated. The barriers to entry were simply buying an airplane, getting a pilot's license, and finding some passenger that wanted to fly from point A to point B. Some folks managed to do well and were buying bigger, faster airplanes and were building mini-aeronautical empires, but by and large, the industry was very much pro-market.

Right on up until 1934 and the Spoils Conference of Postmaster Walter Folger Brown. Brown was a man who hated disorder and inefficiency, so he organized a meeting between the airline chiefteins in which they swapped mail routes, with the Big Four: American, United, TWA, and Eastern organizing with the first three being east/west airlines and Eastern flying north/south.

Brown was happy, as were the heads of the Big Four, but the public was outraged. Pro-business was the watchword of the day. Overnight the airlines had gone from one extreme to the other.

Now, as a reaction to the Spoils Conference, the airmail contracts were reawarded, with the Big Four maintaining most of the contracts, although a few other smaller airlines: Delta, Continental, Braniff and Northwest notably, picking up a few of the routes. But the die had already been cast. Brown had effectively set up significant governmental barriers to entry as mail was the most significant profit cargo for the early airlines.

Another pro-business, anti-market institution that was formed around the same time, at the behest as the airlines, was the Civil Aeronautics Board or CAB. The CAB became quite literally the biggest barrier to entry in the airline industry as it approved new routes and new pricing. The only way for an airline to form without the explicit approval of the CAB was to become an intrastate carrier. Since there were few states (California, Texas and Florida were the real exceptions) that could support an intrastate carrier, there was no real way to enter the market.

The CAB was the ultimate pro-business, anti-market entity. It maintained the competitive positions of the Big Four. It set pricing so that the weakest airline in a market made money. The CAB wasn't interested in allowing the market to work. It was interested in maintaining the status quo.

Now the CAB was sunsetted out of existence, one of the few governmental organizations to have actually disappeared. And once it went away, along with its barriers to entry, competition exploded in the industry. It became even safer to fly, more passengers fly and at lower prices than under government regulation. In short we have gone back to a more pro-market environment in the industry, and while everything is not perfect, it is certainly better than it was in the 1970s.

So what's the lesson to take away from the experience of the airline industry? A pro-market economic environment responds better to the needs of the marketplace than does a regulated pro-business one. Pro-market is best for the consumer and the nascent business; pro-business is the desire and wish of the existing businesses. The two are not the same.

Generally, the convential wisdom is backwards. The Democrats, preferring regulation to market pressure, tend to take more true pro-business positions. Republicans tend to be more pro-market. The Bush Administration, though, tends to take a more true pro-business stance than most Republican administrations (although it can also be argued that what they are doing is simply a continuation of the path started down by the previous administration), which is a bit disappointing, but still much better than the alternatives being proposed by the Democratic candidates.

We really need to start swinging the pendulum back towards the pro-market side of the spectrum. When the market is relatively unfettered is when our economy performs best. We have the most innovation and the best profitability (along with generally the highest employment) during periods of laissez-faire policy by the government.

All in all, I thought the article by Bartlett was pretty interesting. Definitely well worth the read.

Government Spending and Statistics

Dean Esmay has begun another of his usual quality discussions, this time regarding the matter of an article by Stephen Moore and what Dean calls his fundamental errors.

I read the article by Mr. Moore and was not impressed. Dean is correct in that Mr. Moore appears (but it is not clarified) to be talking mainly about the rise in absolute spending since 1940. Further, Moore never acknowledges the population boom that has occurred since 1940 and how that would, in fact, lead to a substantial increase in the absolute level of spending.

But while Dean rants and rails, he also misses a fundamental point. Government spending is about to hit it's highest levels since the end of WWII. Look at this release from the Heritage Foundation.

In 2003, inflation-adjusted spending topped $20,000 per household for the first time since World War II.

Mr. Moore's premise is correct. Government spending is reaching its highest levels since the 1940s. His argument was flawed and poorly supported, but in the end, it was accurate.

But this is not to say that Dean is wrong either. There is, even in the per household number, a significant component of spending tied to the population boom. Baby boomers are coming of retirement age now. As they start to collect Social Security, they are also contributing to the rise in government spending. So the expansion of population does have some significant effect now.

The biggest concern that I have about the rise in per capita government spending is that at the end of WWII, we were spending the majority of our money on defense. Now we are spending on social programs - bread and circus, if you will. Great nations do not survive on the basis of a strong welfare state, they survive based on a strong national defense. Many of the Greek city-states proved it. Rome proved it held true on a large scale. And the lesson has been repeated many times in the intervening 1600 years since the fall of Rome.

60 years ago, we were the Arsenal of Democracy, not because of Social Security spending, but because of our commitment to defense. We won the Cold War, not because of welfare or the Great Society, but because of Reagan's 600 ship Navy, the B-52, the B-1B, the Ohios, the Army and a whole host of other defense related spending.

Spending money on social programs is not a bad thing in and of itself. But to really restrict the government's ability to adapt its spending to meet new threats (or to take advantage of new opportunities) is dangerous. $20,000 of government spending per household in a time of relative peace is simply too much. The last time we were at this spending level, we were fighting against two formidible, organzied, and powerful advesaries. This time we're fighting terrorists - a difficult and expensive task indeed - along with such threats to our society as a lack of golfing awareness in St. Augustine.

Our priorities are getting out of whack. The longer we keep spending like drunken sailors on payday, the more we put our long term security at risk.

And that is a tradeoff I don't like.

Withdraw From NAFTA & The WTO?

OK, I know that some of you will complain that this post is like shooting fish in a barrel, but I'm going to take on one of Rep. Kucinich's worst ideas from last night's debate. Specifically, he called for (and promised if elected) a full and immediate withdrawl from both NAFTA and the WTO. He brought out some really nice graphs that showed a significant drop in something (I'll assume that they did represent manufacturing jobs as he claimed) at some point in time (I'll even assume that that time corresponds with NAFTA and the WTO). Despite the graphs, I absolutely believe that withdrawl is the wrong path to take.

First, I find it very curious that in general the biggest protectionists in politics are almost always the same ones that want us to sell out our sovereignty to other nations. They want us to be internationalists and engaged in the political realm and isolationist in the economic. Never does it occur to them that the two are inextractibly linked.

The want us to be a totally self-sufficient nation, able to produce everything we need in order to maintain our standard of living. That is a nice, utopian goal. But as with most utopian goals it is unachievable.

Even during WWII, when 10% of the world's economic output used to travel over the same hill in Pennsylvania, the United States was not completely self-sufficient. Were we the biggest manufacturing plant in the world? Yes. But we still needed energy and material inputs (generally oil and exotic materials) from other nations.

Now, we are even more dependent on others, particularly those in the Middle East. Could we bring home more manufacturing? Sure. Everything that is currently being manufactured in Asia or South America or Europe could most certainly be made here - by American workers. It might cost more, but surely the increase in employment in the United States would more than offset the higher costs, right?

What the isolationists want to dismiss is the concept of economic specialization. We used to always talk about it as such:

A given unit of labor in the US can be used to either grow 1 bushel of tomatos or to produce 5 semiconductors. A similar unit of labor in Mexico can grow 2 bushels of tomatos or can produce 3 semiconductors. Each nation has 10 units of labor available.

The US would be capable of producing a maximum of 10 bushels of tomatos or 50 semiconductors. We could also choose to allocate labor to produce say 5 bushels of tomatoes and 25 semiconductors.

Mexico similarly would be capable of producing a maximum of 20 bushels of tomatos or 30 semiconductors. Or the could choose to produce 10 bushels of tomatos and 15 semiconductors.

Now obviously the US is more efficient at making semiconductors and the Mexicans are better at growing tomatos. If each nation specializes, there are 50 semiconductors and 20 bushels of tomatos available to divide between both nations. If the US trades 25 semiconductors for 10 bushels of tomatos then the US has 5 more bushels of tomatos than they would have for having produced 25 semiconductors for domestic consumption and the Mexicans would have 10 more semiconductors than if they had produced 10 bushels of tomatos for domestic consumption. Both sides benefit from the trade.

We could bring all the manufacturing back home that Kucinich is up in arms about, but how many high-tech jobs would have to be surrendered? How many service jobs would have to go by the wayside? Fact is, our economy is really geared more towards service than it is towards manufacturing any more. To ramp up our manufacturing to be as close to self-sufficient as possible our standard of living would decline. Manufacturing is no longer our specialty.

That's not to say that we should completely abandon manufacuring. As I like to say, everything in life is a balance. Manufacturing is not only an economic concern, it is also a national security concern. Prudence says that we need to maintain a certain level of manufacturing capacity in the event that conflict breaks out and we become isolated from our suppliers. The trick is maintaining the balance.

Kucinich wants to push us out of balance. He's willing to sacrifice the economy in a quest for more manufacturing jobs. Sounds an awful lot like a command economy to me.

The Soviet Union already proved that the government is not the best source for determining the proper mix of jobs in the economy. That is a task better left to the invisible hand of capitalism. The government does have in interest in promoting a degree of economic inefficiency in the interest of security, but nowhere near the degree that Kucinich is proposing.

Withdrawing from NAFTA and the WTO is a bad idea precisely because it would force the United States to become more of a manufacturing economy overnight.

Why Drugs Are Expensive Here, But Not There

Senator Lieberman in the Democratic debate this evening mentioned that he believes that it is wrong that prescription drugs generally cost more in the US than they do overseas. He goes on to blame a number of factors ranging from foreign price controls, to US import restrictions, to unfairness in the way the drug companies treat American comsumers. All interesting points, but they ignore one of the biggest costs: government interference.

FDA red tape and Medicare/Medicaid squeezing of prices both put enormous pressure on drug company profit margins. Like it or not, the drug companies don't exist for some greater altruistic motivation, the exist to make money. When they invest millions upon millions in R&D they're going to expect to earn a respectable return on that investment when the drug actually goes to market.

Foreign price controls make earning that return more difficult. But foreign price controls, while beneficial to the foreign nations in the short term, also put tham at great risk long term. Think of the major drug names: Pfizer, Bristol-Myers, Schering-Plough - they're almost all American based companies (there are some exceptions, but not many). With the designer drugs - the newest, most effective ones on the market - countries with price controls really risk losing their access to these drugs. If Pfizer decides to quit selling their brand name drugs to Canada, the Canadians don't have a pharmaceutical industry sufficient to pick up the slack - or to research new drugs of their own. Many of the price controlling nations are dependent on the continuing goodwill of the American drug companies to keep selling the drugs at restricted prices. They're gaining the reward of lower prescription drug costs, but at the risk of a nearly complete implosion of their medical system should the drug companies decide to quit playing ball on these terms.

Now as to the US import restrictions, I don't like them in general, but they do have a real point in this issue. Many countries don't have the same inventory controls required for US distributors. Expired medications, watered down, misfilled prescriptions are more likely to occur with less regulated foreign pharmacies than they are with American ones. Canada and most of Europe generally do fairly well in matching American standards, but not all the foreign mail-order pharmacies are from these nations. The additional safety regulation of the American pharmacies is both proof of the benefit and of the costs of the FDA regulation in the US.

As for the perceived unfairness, America's health care system is still one of the most respected in the world. Every other nation with price controls (and therefore socialized medicine) has some form of rationing. It is incredibly rare to hear stories of rationing of medicine in the US, but folks from these other nations sure seem to want to figure out how to get here for their health care. We may pay more, but we also get more.

I don't think that Lieberman is on the right track with his seeming desire to either institute price controls or to allow the importation of US-produced drugs from other countries. You want to find a way to subsidize drug R&D? I might be convinced to go along with that. But to reduce the drug companies to an uncompetitive status in the capital markets by fiat? No way.

We first need to find a way to rationalize the FDA. Red tape is a significant contribution to the cost of drugs from the research phase to distribution. Find ways to cut some of the regualtory fat and prices should come down - some. Let's try to find other ways to make this work.

But the status quo is still much better than socialization.

Islam Doesn't Slow Economic Progress?

Marcus Noland has released a study in which he promotes the theory that Islam does not slow economic development. I disagree.

Take out the oil wealth in many Islamic countries and what kind of economic structure do you find? Not much of one. It tends to be tribally developed and geared more towards tourism and religious pilgrimages than it does towards any kind of manufacturing or wealth creation. There is virtually no economic diversification and therein lies the root of the problem in the Islamic economies.

The centrality of religion in the Islamic world tends to squash any real efforts towards economic gain. People are not encouraged to live life so much as they encouraged to prepare for death. Christianity went through a similar spell during the Middle Ages. It wasn't until Europe experienced the Renaissance and Enlightenment that we truly began the process of creating wealth.

The Christians of the Renaissance realized that religion and wealth do not necessarily need to be mutually exclusive. Muslims have not reconciled the idea of creating wealth, which can in turn be used to honor Allah.

Islam, right now, is so pervasive in its host societies as to discourage and repress the spirit of capitalism. Mr. Noland is correct in asserting that Islam is not the only reason for the slow and backwards economies found in the Muslim world. But to ignore or dismiss the contribution of Islam to the backwardness is to deny that there is a problem.

Only a true critical assessment of Islam's overly pervasive role in the society can help to bring about the changes needed to improve the lot of the Muslim world.

Dow 10,000. What Does It Mean?

Everyone seems to be making a big deal about the Dow Jones Industrial Average passing through 10,000 again. Republicans are simply gushing with excitement; Democrats are simply moaning as if they had been mortally wounded. So what does Dow 10,000 really signify?

Nothing.

It merely means that the 30 stocks of the average have combined to reach a certain level at which there aggregate average works out to 10,000. It doesn't mean the economy is booming. It doesn't mean that everything will be a utopia anytime soon. It's a number, that's all.

I remember the first time the Dow went through 10,000. People were excited. It was an amazing psychological achievement, but in the grand scheme of things, it really didn't mean anything then either. The stock market isn't an accurate guage of the economy. Sometimes it leads the economy; sometimes it lags. Dow 10,000 was, and still is, a psychological barrier. Just like 9,500 or 10,500. Passing it is nice, and it feels like an achievement, but it really doesn't mean anything.

Show me unemployment dropping. Show me steady gains in the GDP. Show me something tangible in the economic numbers. The hubbaloo around Dow 10,000 is much ado about nothing.

Free Trade Vs. Economic Health

The Weekly Standard has a pretty good article about the recent gyrations of the dollar in comparison to other currencies and how it might and does affect us in the US.

As I read the article one of the key points I picked up on was this:

Since China and Japan are intervening in currency markets to prevent the dollar from getting dearer in terms of their own currencies, the brunt of the readjustment is falling on the euro and sterling. And a heavy brunt it is. The euro is now above $1.20, a record, and the pound is above $1.70. That has made goods manufactured in Europe and Great Britain more expensive in America and, in the case of the eurozone, where domestic demand is weak, threatens to turn no-growth into slump.(emphasis mine)

The problem with Europe plunging into a contractionary environment is that it is one of our larger trade partners. The budding recovery in the US is still vulnerable. If our European partners become unable or unwilling to purchase from us, it could very well spell the end of the our expansion.

The author also points out how the Euro and the Pound absorbing the entire effect of the weakening dollar can harm the US economy through higher oil prices:

Oil prices have remained above the top of the OPEC cartel's target range of $28 per barrel. But producing nations are finding that they can buy less with their dollars. Whereas the Saudis would once have had to sell about 5,000 barrels of oil at the top of the cartel's price range in order to earn enough dollars to pay for a brief, £100,000 visit to their favorite haunt, London's Dorchester hotel, they now have to sell about 6,000 barrels at that same price to pay for enough sterling to cover the cost of their stay. So, they have in effect abandoned their $28 ceiling, and are keeping production low enough to support prices in excess of $30 to offset the reduced purchasing power of their dollars.

Bush asked for restraint. But Saudi oil minister Ali Naimi isn't restraint minded. So he used last week's OPEC meeting to announce, "The dollar is weakening, and purchasing power is quite weak, so [the current high price] is okay." After all, Naimi wouldn't want to risk his job, and possibly his neck, by allowing the living standards of the 5,000-7,000 Saudi princes to decline. Bad news for American consumers.

So what's the answer? The problem really seems to lie in China's insistence (and Japan's to a smaller degree) that they will not allow an appreciation of their currency vis-á-vis the dollar. I'm not a big proponent of tariffs and restrictions, but I am starting to wonder if we may be at a point where our overall economic health would be best served by artificially "creating" an effective depreciation of the dollar versus the yuan and the yen. I hate the idea of our going down the road of protective tariffs, or even worse yet of a twenty-first century Hawley-Smoot, but if the alternative is allowing them to push our economy back into recession through their own protectionist monetary policies, well which evil is the lesser evil?

At what point does our national economic health trump the ideal of free trade? It's an interesting question.

More Economic News

Getting a late start on things as I came back home and slept for a while after getting the kids off this morning.

On the economic front today, we have a wonderful announcement from the Labor Department that worker productivity grew by 9.4% last quarter, the highest since Q3 of 1983 when it grew at 9.7%. I believe that if this sort of growth (meaning positive productivity growth, not necessarily at 9%+) then we might be seeing the beginning of a good, strong labor market again.

In a way, the economy is like a person. When you know that you have to make a extraordinary effort in order to pull something off, you almost always have a reserve of capability that you can call on. No one does, or can, perform at a 100% effort level all the time. It would simply wear you down.

The economy is the same. We always have a short term burst capacity in the economy, but the higher productivity cannot be sustained indefinitely. Right now, employers are paying overtime instead of hiring new employees. The current employees are responding with higher productivity, but if this level of output is attempted to be sustained at current employment levels, eventually companies are going to find their productivity tanking due to higher absenteeism and higher turnover. At some point, and probably sooner rather than later, real hiring has got to start or else the recovery will fail.

The higher productivity numbers are certainly not an immediate improvement for the unemployed, but they are a sign of hope for the future.

Unless, of course, you read the Reuters take on this story. They take a story that should engender at least a base level of optimism and try to downplay it with the following quote:

But while already strong productivity was revised even higher in the third quarter, the news was tempered by a drop in U.S. mortgage applications for the week ended Nov. 28.

Sounds scary, huh? So what did the Mortgage Bankers Association have to say about it?

"As expected, last week was a slow week for mortgage application activity. After adjusting the mortgage indices for the impact of the Thanksgiving holiday and other seasonal factors, the purchase index was down only 3.9 percent” said Michael Cevarr, MBA's manager of member surveys. (emphasis mine)

Hmm. The people that make their money selling mortgages don't seem to be too concerned with this at all. Maybe it had something to do with the fact that the week of 11/28 was Thanksgiving weekend. Maybe they realize that all the refinancings that could be done are pretty much done. Refi's are now down to 50% of the mortgage market. That means that more often now, mortgages are being originated for real wealth building purposes (home purchases) rather than for simply saving a few dollars. Again, this is another good sign for the economy. Home purchases lead to other purchases (like furniture, appliances, and so on), which helps to lead the economy into a more stable footing.

To be sure, things still aren't where they need to be. But with every report coming out, we're beginning to find more reason for optimism than pessimism. If this trend continues, I expect to see a much better economic climate including more jobs and higher consumer confidence.

9.4% is a great number, not for what it means now, but for what it potentially means down the road.

3Q GDP Revised Up To 8.2%

But don't go getting all giddy yet. While GDP growth was revised upwards from 7.2% to 8.2% for the 3Q we're still not out of the woods.

Politically for Bush this new number can be a blessing or a curse. If the economy can sustain this kind of GDP growth for the next couple of quarters, Bush will effectively negate the "It's the economy" argument of the Democrats and will have an even easier path to reelection.

If growth slows (and 8.2% is really an unsustainable number for any length of time given current monetary and fiscal policies of the government) then Bush may be exposed to a pretty harsh assault campaignwise on the economy. If the growth rate drops to 2.5%-3% (a more sustainable number), Bush faces the probability that the Democrats will assail him for a false recovery. They'll talk about how the declining rate of growth is pointing to the fact that we have not recovered from the recession, and they'll blame the tax refund checks for providing the one quarter boost.

They would be wrong, growth is growth, whether it be at 8% or 3%. A recession is not characterized at all by growth.

They would however be right in asserting that we still have not seen a complete recovery from the recession. Right now, companies are boosting productivity by increasing overtime for existing workers. I recently read somewhere (no link right now, I'll try to find it tonight) that overtime is at its highest level in years. For a complete recovery, companies need to start hiring more people, instead of laying off and increasing overtime. Yes, layoffs and overtime provide a short term productivity and profit boost, but ultimately they will harm the business more than they do it good (higher absenteeism and higher turnover). It is also concerning that business inventories are not reducing as fast as they were originally stated to have. Excess inventory will hold back the growth of the company by tying up assets that could be put to more efficient use elsewhere.

Don't get me wrong. Things are looking much better than they were even back in June. I think that for now the threat of a deflationary recession has passed us by. But, as with everything in life, the truth lies somewhere between the two extremes. 8.2% is a great number, but it is not proof that we have entered a new economic age. At the same time, just because the jobs are not being created as we would normally expect to see at this stage of a recovery does not mean that the end of the world is here either.

More Poorly Done Economic Reports

Last night, I discussed the MSN mutual fund scandal article and how it was full of mis-statements and manipulations. Tonight, it is Reuters distorting the economic truth.

The 7.2% growth rate in GDP posted during the third quarter was unsustainable at this time. But 4% is not a bad number. If we could keep the economy growing at a steady 3-4% we would be doing fine. Is it a slowdown from the 7.2%? Yeah. But it is a slowdown to reality.

Really, out of everything I see here, the only really concerning items were the spike in food prices and the corresponding spike in wholesale prices.

Food is an inelastic demand. People always have to eat and it is unlikely that we will significantly change our food purchasing habits to help buy that new refrigerator, TV, or car. A sustained rise in food prices will lead to a permanent reallocation of spending away from consumer goods. This is a long term concern.

The other thing that I'd want to keep an eye on is the spike in PPI. If it is a one time spike, like the market is assuming, then it's no big deal. But if PPI persists at this new, higher level, we're going to see more companies struggle. We'll also eventually see the CPI numbers following suit and rising, which introduces the specter of inflation to the equation again (didn't think I'd be talking about that bug-a-boo so soon again). Again, though, this is a long term concern.

The most important thing right now is that the economy is still growing at a decent clip. We've got to find a way to keep the economic tide flowing in the right direction.

Things still aren't great, but they're also not as bad as the doomsayers would have you believe, either. Keep everything in perspective. Just because GDP growth may be slowing down does not necessarily mean that we are heading into a failure of the recovery.

Supply, Demand, Price Controls, Economics, Etc.

While I had the honor of compiling this week's Carnival of the Capitalists, one of the articles that was submitted (by Jonathan Wilde of catallarchy.net) was an analysis of an article by Paul Krugman about a babysitting co-op in the Washington DC area.

Now Jonathan did an excellent analysis of the article itself, one that I wholeheartedly recommend reading, and I do not plan to recreate his wheel, as it were. Instead, I want to use the article to help illustrate how inflation and deflation are both vital to a healthy economic cycle.

The biggest flaw that I saw in the co-op's scheme was that of price controls. The value of the coupon was pegged at 1 hour of babysitting per coupon. Period. It did not vary upwards in times of great demand; it did not vary downward in times of little demand. Consequently, the only tool available to influence the "economy" was the size of the money supply, which is not entirely realistic.

Jonathan also pointed out that they coupons used in the co-op were not true money, as their use was limited. They could only be exchanged for other babysitting services. In doing full blown economic effectiveness analysis, this would be a significant factor hampering the extrapolability of the results, but for the discussion I want to have, this isn't really a factor.

Hypothetically, let's eliminate the price controls in the co-op and create a given coupon supply. The number of coupons is a fixed number and their par value (or issuing value) is, as it was in Krugman's article, 1 hour/coupon. Further, we're going to say that there is no banking mechanism, no issuance of additional scrip, and no "virtual" coupons. Every coupon is paper, there is no credit, and every transaction is paid immediately in scrip.

Now when the coupons are first issued, people will freely exchange them for 1 hour of babysitting, just as the par value indicates. But what happens as we head towards winter and people decide that they need to start saving coupons, perhaps in anticipation of the State of the Union? The demand for babysitting services naturally declines, but the demand for coupons is still there. So how can people acquire more coupons?

Well, we have already prevented the co-op from issuing more coupons, so the value of the coupon should naturally begin to deflate. Coupons should begin to be valued at say 2 hours per coupon, maybe more. Eventually, prices will drop enough (coupons will buy more hours per coupon) to begin to stimulate activity again. People who want to collect and hoard coupons will have them become available and people who maybe have more coupons than they really need or who want to spend more time going out will begin to use more of them as they see the value increase.

Eventually, though, the spenders will need more coupons and the service providers will need to use the co-op services. At that point, the coupons start to flow the other direction and the value stabilizes at the new lower level.

But then what happens when the State of the Union comes up and everyone wants to go? Now you have huge demand and little supply. Prices will begin to rise (each coupon will buy fewer hours of babysitting) until a point is reached where there are enough people willing to spend the night at home working that the need is satisfied. That point may be at, say, 10 coupons per hour. Inflation will have eroded the value of each coupon substantially, but eventually there will be more people willing to work than that price level will support and prices will deflate back towards a reasonable level, followed by the whole process running its course again.

The cycle I've just described could be described something like this: contraction-bust-growth-boom. Look at a sine graph for a graphical representation of what
it would look like. It is a "perfect" cyclical model.

Unfortunately, the textbook, theoretical model does not exist in the real world, as we all know.

Let's look at what might happen if there was a bank involved in the process that was capable of creating and destroying scrip at will, not unlike the Treasury (although the Treasury does it through the issuance and open-market redemption of bonds).

In the contraction phase of the cycle, the bank could, as Krugman proposed in his original article, make more scrip easily available through low interest rates (maybe borrow 10 scrip, only repay 11) to help stimulate demand. It makes sense to do so, because it avoids the harsh effects of deflation on an organization (in this case the co-op), which has debt as part of the capital structure. The risk, however, is ending up in the dreaded liquidity trap where no amount of Keynesian pushing the string will stimulate demand.

During the boom part of the cycle, the bank could, attempt to contract the scrip supply by making it more expensive to borrow (say borrow 10 and repay 20), which would contract the scrip supply by the process of some people paying off their debts, while limiting the amount of scrip being created. This would help to avoid inflation by reducing the number of coupons available to chase after the limited supply of babysitting time (it limits how high up the demand curve the economy can go). The risk here however is that if people have been borrowing scrip to repay with scrip, it makes sense to encourage the continued rise in prices through further borrowing as it then takes less effort to repay the debt than the value received in incurring it.

Notice the similarities between the two. In the first scenario, we are expanding the money supply to encourage spending, thereby discouraging deflation. It is assumed that a little inflation is a better alternative than a little deflation. In the second scenario, the goal is to rein in inflation, but it is still assumed to exist.

In other words: inflation=good; deflation=bad.

Here are the two problems I see with that the actions of the bank. First, deflation is the monetary equivalent of a check and balance in the government. Deflation discourages the piling on of debt by making it more difficult to repay that debt down the road (imagine the person who borrows 10 coupons for 1 hour of services, only to have to repay 20 coupons in which they receive 1 coupon for every 2 hours of babysitting - a 40 to 1 ratio in hours).

Inflation, conversely makes saving less attractive by devaluing the worth of each coupon (imagine the person who hoards 10 coupons at 1 every 2 hours only to use them at a rate of 10 per hour - that's a 20 to 1 ratio). Too much of either extreme, savings or debt, is bad for the economy. Inflation and deflation are the checks against the extremes. By cutting out one, we remove one of the consequences of poor economic decision-making.

The second problem I have, is that constant inflation erodes confidence in the value of the scrip. You run into a scenario where people eventually ask what the point is of working for a coupon that will get you half of what you put into it, so they either remove themselves from the economy by transitioning to a barter system, or they immediately spend their earnings, regardless of the utilization value, in an effort to stave off the effects of inflation, when if fact they are simply exacerbating the problem (this is where it turns into hyperinflation).

In our economic system, we have virtually eliminated (on an economy wide scale, in certain industries the effects are still felt and even then I would argue that they are offset to a large degree by substantial productivity gains in those same industries) deflation as a real risk to business today. That's not good. There is no check against out of control borrowing and we're now starting to see the effects of an economy being strained under the weight of simply too much debt. I think that we're at a crossroads, economically right now. Our nice little 2-3% inflation rate has been outstripped by our mushrooming debt. If businesses start hiring large numbers of people again, I think we're going to see the inflation rate increase significantly. If they don't start hiring pretty soon, I think we're going to see debt induced deflation - which will not be pleasant at all, as each default will lead to more defaults as everything is based on a house of cards, where one debt backs another debt which in turn is backed by another debt which is backed by the original debt. Default on any one and the whole group comes down.

What really scares me is that a form of the circle may, in fact be what our entire economic system is based on. In another article from the Carnival, Mike Northover of Master of None did an excellent post on the Real Bills Doctrine, in which it is proposed that our currency is in fact backed, backed by commercial paper issued by corporations and bought and held by the Fed.

Before I go too far into this discussion, a little look at what commercial paper is. Commercial paper is basically an IOU written by a company in which they promise to pay you back x number of dollars plus interest in say 90 days. Commercial paper has absolutely no backing; if the company defaults there is no recourse - you're just out of luck. Generally, commercial paper is issued by the largest and most stable companies out there as a way of doing short term financing. It saves the companies on the costs of doing a bond issue and generally commercial paper is easy to roll over. It is usually attractive to investors because it offers a combination of decent return (due to the risk associated with no recourse) and relative safety from the short time period.

But what is the commercial paper backed by? It is backed by the full faith and credit of the issuing corporation. One of the reasons why commercial paper is considered to be such a decent short term parking place is because it is denominated in dollars. People like the perceived strength and stability of the US dollar, which is fine. But it means that to a degree, the value of the commercial paper is backed by the perception of the US dollar (GE commercial paper issued in Mexican pesos will not be as valuable to a Mexican as a dollar denominated scrip is to an American because of the perceived risk in the peso, even removing exchange rate risk).

And according to the real bills doctrine, the value of the dollar is backed, to an extent, by the value of the commercial paper. In other words, the paper provides some backing to the dollar, which in turn provides some backing to the paper. But so what, you say?

What happens in the event that some event shocks one side of the backing or the other? Say an active paper issuer like GE goes bankrupt? If real bills holds true, the dollar should lose some of its luster, which in turn would devalue the rest of the commercial paper, which would take the dollar down more, so on and so on and so forth.

Think it can't happen? It already has once. In 1970, the Penn Central railroad, then the largest issuer of commercial paper in the market, went belly up. It was at the time, the largest bankruptcy in US history. It can happen. It has happened. The question is, could our economy, if the value of our money is based on the real bills doctrine, withstand another shock like that? Luckily, in 1968 when we left the gold standard, we were about two years from the end for Penn Central. The Fed would have had an opportunity to avoid stocking up on PC scrip. But even so, the revelation of the true depths of the problem at PC came out in early June of 1970; by the end of the month they were in bankruptcy - and all the paper holders were SOL.

Today, if something like that were to happen, if real bills is at work (which I don't doubt it is), it could be a devastating blow to our economy. Particularly now that a number of companies are issuing Euro denominated commercial paper, which now adds in exchange rate risks on top of everything else. A blow to the dollar could dry up significant parts of the paper market, leading to more insolvencies, further hurting the dollar and putting us into a vicious circle until some sort of equilibrium is reached.

But here's something to consider that kind of ties together both parts of this post: We left the gold standard in 1968, Penn Central went bankrupt in 1970, and Nixon imposed price controls in 1972 that lasted until 1974. This all coincided with the beginning of the bear market of '70s and was followed by stagflation. It was nearly 15 years, until about 1983, before we were able to pull out of the issues caused by the events of the late '60s/early '70s. Recently, consumers and corporations alike have seen an explosion of debt burdens and we're now possibly approaching the end of the debt boom. Our economy is sick, there is no doubt about that (and before someone says look at the stock market, that is not a reliable indicator of the health of the economy.), what is in question is whether or not the sickness is getting better or worse.

I think that we've harmed our ability to rectify difficult economic circumstances by taking away one of our check and balance tools - deflation. It is a necessary evil to maintaining a healthy economy. Just a few months ago I was arguing the need to depreciate the dollar to try to export our way out of recession. The more I study the whole situation, the more I'm becoming convinced that we need a broad based deflationary environment for a short period of time to try to introduce a measure of rationality into the economy. The biggest obstacle I see is that we have accrued so much debt in anticipation of never ending inflation that deflation would be catastrophic to many. We may have inflated our way into a situation where we can no longer inflate, but we cannot afford to deflate like we need. We, too, may have hit a liquidity trap, and may be in for a long ride while the economy tries to absorb and/or wring out all the extra debt created money floating around out there. I'm not sure what's worse: rapid fire deflation where all the pain comes now and we can begin rebuilding, or a long drawn out economic collapse, like Japan has gone through for the last 10 years, where the pain just keeps coming and coming and coming in little increments for a long time before you can begin the process of rebuilding.

Do I have the answer? No. Just kind of thinking out loud here. And getting really tired of seeing supply and demand curves in my head.

What Is A Promise Worth?

Mike Northover and myself have been going back and forth over the gold standard issue. Pretty much we've come to the point where I favor some sort of a return to the standard, whereas he wants to continue on with the current fiat system. Today, however, he linked to an article from The Economist which looks at how our current economy is based on promises and how that may become a problem down the road.

In my last post on reverting to a gold standard (which by the way, would not need to be strictly a gold standard, a bimetallic or even tri-metallic system could work just as well), Thomas left a comment, which I think is rather important for a number of different reasons:

With GNP growing 2-4% a year can we really dig up enough new metal out of the ground to keep up? Since we clearly can not, than a gold/silver standard commits us to deflation. Good for people with money in the bank, very bad for most of the rest of us with debts.

Thomas is absolutely correct in his assertation that reverting to a gold standard would lead to deflation, which is bad for those with debt (like me also, Thomas). But the real problem isn't in the deflation itself, it's in the way our economy has been being primed for the last few decades.

Prior to moving off the gold standard, economically we went through cycles of inflationary pressures and deflationary pressures. Inflation was caused more often than not by the consequences of excess savings flooding the market chasing after too few goods. It encouraged businesses to expand, taking on more debt in the process. Deflation was more often than not the consequence of too much debt and the resultant overexpansion it created. Deflation weeded out the inefficient companies and forced the others to streamline in order to maximize efficiency and therefore profits. Neither extreme was pleasant, but both played an integral role in maintaining our economic efficiency.

Once we left the gold standard, it became politically unacceptable to suffer through the rigors of deflation. Companies went bankrupt; people lost their jobs and life was generally hard during those times. Through a constant expansion of the money supply, deflation could be warded off, with the added side benefit of companies being able to repay debt in inflated dollars, rather than in virtually nominal ones like they had in the standards' days.

And what has been happening for a while is a constant expansion of debt coinciding with a steady deterioration of savings. Companies are willing to expand through debt because they expect the payments to be inflated into reasonable amounts. Consumers take on excessive debt on the expectation, justified or not, of constantly rising incomes to make their debt loads manageable. This is not healthy behavior.

One of the great virtues of the gold standard was that it introduced real consequences to the assumption of debt while simultaneously providing real incentive for saving when the balance started to get out of whack. No company or individual was be willing to take on additional debt loads if they felt that their revenue or income was going to be decreasing, as servicing the debt load becomes more difficult. On the contrary, the would be more apt to save that money for a time when it would be better spent. When the time came, the cash was on hand to take advantage of new opportunities, without having to immediately resort to debt for funding.

The lack of deflation since we left the gold standard has given many people a false sense that deflation is an absolute evil with no redeeming attributes and that we are no longer subject to the inflationary/deflationary cycles of economic history.

Deflation is uncomfortable. Deflation is unpleasant. But it does have a balancing effect on the debt/savings continuum.

And there is nothing that has made us exempt from the economic cycle. Just as companies go through cycles, so to does the economy. Inflation and deflation are the growth and contraction phases of the economic cycle. Both are necessary to the maintenance of a healthy economy.

Which is something our debt-loaded society desperately needs.

Standards Vs. Fiat

Sorry if this post has any spelling errors. This computer doesn't have a spellcheck on it and my skills are sometimes suspect at best. I'll run it through Word when I get home this evening.

Mike Northover has been filling in for Michael Williams over at Master of None, and he's been doing a pretty admirable job, I must say. One of his favorite topics to blog on seems to be economics, which of course causes me to stop and read.

In one of his posts last night he makes the statement "I'm a big fan of the federal reserve, and the fiat monetary system that we have in place..."

I'll agree that the Fed has performed it's job very well given the tools it has at its disposal. The Fed trying to steer the economy is like me trying to steer a car down a steep mountain road full of switchbacks, while blindfolded and having beat a sledgehammer against the tires to make the car turn. It's not an easy task, and Greenspan and the Fed deserve a lot of credit for not sending us through the economic woods.

But I have to disagree and say that the fiat monetary system is not a wonderful idea. The risks associated with it are enormous, and the benefits pale in comparison.

The fiat system is based on the "full faith and credit" of the government issuing the cash. This is wonderful if you have relatively responsible people in charge of the economy and the printing presses, as the US has since Bretton Woods. But what if you get someone irresponsible or ill-informed about how the economy works?

One of the biggest problems with the fiat system is that there is no restraint mechanism in place. With the gold standard there was always the requirement to acquire more gold to back the currency. With the fiat system, the presses can run 24/7 just printing, printing, printing and there is nothing immediate in the system to make it stop. In fact, it becomes a self-sustaining inflationary cycle.

In the immediate short term, printing more money has some outstanding benefits for the government. They can use that money, backed only by the government's faith that it's good, to pay for more social programs, to pay for more infrastructure, or any goofball measure they may come up with. Politicians get a short term boost, the economy gets a short term boost, and everyone is happy. Right?

Not exactly. In the intermediate to long term unless that money is taken back out of the economy, usually by cutting spending somewhere or by raising taxes, we enter a situation where we have too many dollars chasing too few goods and services. Prices begin to rise, which leads to higher wages, which leads to more money chasing the limited supply of goods and services, and so on and so on and so forth. Welcome to the vicious wealth-sapping inflationary cycle.

Think it can't happen to us? It happened to ancient Rome. It happened to Weimar Germany. It has happened to almost all of the South America nations at some point. What makes us so special as to be exempt from the effects of an inflationary economic implosion?

Nothing does. The only reason it hasn't happened already is because we have had people in office who upheld the faith portion of the fiat system. We have had people in office who acted responsibly. But what happens if the economy stays stagnant or even starts to regress again?

The lure of easy money might become too much for many politicians. We could very well end up with a "reformer" getting elected. If things are bad economically, many people who don't understand the basis for the fiat system may accept or even embrace the idea of simply printing more money to pay for economic stimulus. It would never occur to most people that an inflationary or hyper-inflationary cycle brought on by irresponible printing would destroy our fiat monetary system by destroying the faith portion of the backing.

How easy might it be to rapidly increase the money supply in clandestine ways? Try this on for size: we are now going onto our third variation of the $20 bill in the last, what, 10-15 years? Now, I believe that the Fed is taking the old $20s out of circulation and destroying them, just like they should. But if they didn't, this would effectively triple the amount of $20 bills availble. Add that to each denomination and that would be a massive influx of new, inflationary pressuring cash entering the system. And many people wouldn't notice right away, as it could be hidden under the guise of improving monetary security.

The fiat monetary system is very similar in a way to the concept of communism. They are both wonderful, utopian theories that ignore the realities of human nature. Just as you will eventually find a slacker leech in a communist society, you will eventually find an irresponsible economic leader in a fiat monetary system. Just as the slacker destroys the faith required to maintain a perfect communist system, the irresponsible economist destroys the faith needed to maintian the fiat monetary system.

The ideal, though unwieldy, solution would be to return to a system of gold and silver coinage. With that, we would have an ability to immediately determine, through specific gravity testing, the quality of the money being presented and can make valuation determinations based on the purity and quantity of the metal being offered. It also has the benefit of tying the government to an absolute fiscal responsibility as the only way to mint more money would be to obtain more metal.

Gold and silver certificates are a compromise solution. In theory they are backed by a specific quantity and fineness of metal, but in reality, the government can print more certificates than they have metal to back. This is again due to human nature. Even in the midst of a run on the metal, not everyone would attempt to redeem their certificates. The number of non-redeemers is a number that can be calculated and predicted, just like the number of no-shows for an airline flight. Using that information, the government can exceed the limitations set by the metal backing, to a point. But at some point, fiscal responsibility is still forced upon them by the backing requirement.

Since Bretton Woods, the US has really dodged a bullet. We have had responsible people in positions of power who did everything they could to protect the full faith and credit of the Federal government. But do we really want to base our future on making the right decision every single time? Or do we want to have a system in place that is resiliant and allows for correction of errors in judgment?

The fiat system requires perfection. Mistakes cannot be made or else the whole system collapses. And that is not a good situation for something being run by humans or politicians.

Personal Retirement Accounts

As I was reading along this afternoon, I came across this article which has done some studies on the benefits of switching over to PRAs in place of total dependancy on Social Security.

I like the idea of PRAs. I believe that giving people options is the right thing to do. Not everyone will take advantage of those options, and much to the chagrin of the socialist crowd, the outcome will not be equal, but such is life. Choice is better than no choice.

I just worry that with studies like these, there are probably some important factors that may lead to the actual results being very different from the theoretical results, giving the socialists anti-choice ammunition.

Using past returns to extrapolate potential future returns is, of course, no guarantee, but it is usually a pretty good indicator, assuming that the macro environment in the market stays close to the same. PRAs, however, would change the market environment. Currently the Social Security money is just sitting there, doing nothing. With PRAs, it would rapidly flood into the market (both the stock market and the bond market) and would distort prices. Dumping a few hundred billion or even a couple trillion dollars into the market would significantly push up the demand for securities in the short term, leading to higher prices and lower returns. This phenomenom would be followed very soon after by a drop in prices as all that demand dried up after the initial establishment of the PRA accounts. Ultimately, a few people would lose some money in the whole settling out process, which would lend a false credence to the anti-PRA crowd.

The long term gains in retirement funding would far outstrip the short term pain from the settling out gyrations. The hardest part is going to be making it through the short term.

We need the PRAs. We just also need to be sure that we know all the potential pitfalls involved before we get started.

Do We Want To Be Like France?

A few days ago, CNN/Money had an article that discussed a gentleman, John De Graaf, who is trying to get the US to switch to a European style labor framework: i.e. a 35 hour workweek, 11 mandatory paid holidays and mandatory vacation time. He asserts that we need to work less in order to improve the quality of life in the US.

I'll agree with the idea that we are overworked, but I don't think that we need new government regulations created in order to rectify the situation. Everything about our capitalist economic system is geared around the idea of opportunity costs. At any point, you have the option of working fewer hours. No one is forcing anyone to work against their will. There is no legal requirement that you must work "x" number of hours in a week. However, if you choose to work fewer hours, there is an opportunity cost associated with that choice. You may not have the opportunity to work your dream job. You may not be able to find a job that pays quite as much, either on an hourly or an absolute basis. But that is a choice you get to make.

Do you want more money and less free time or less free time and more money? The choice is already yours. Do we really want a system that imposes that choice on us? I don't.

I know that some people would put forth the argument that people really are being forced into working more hours by the rising cost of living. That argument doesn't really hold water with me and I'll tell you why.

Most people who are complaining about the rising cost of living are up to their eyeballs in debt, have two brand new cars, just took a new home equity loan and have never bothered to try to live within their means. Too many people aren't being caught up in a rising cost of living as much as they are being caught up in a rising relative cost of debt servicing. For the most part we just carry way too much debt.

All of this goes back to opportunity costs. People aren't being forced to work more hours because of the rising cost of living. They're being forced to work more hours because they mortgaged their own future earnings, and the bills are coming due. The choice was made long ago when the debts were first incurred, the cars bought, or the house refinanced. The effect is one of the complainer's own choosing. They chose to give up free time now in order to spend more then. They may not have consciously thought of it then, but the law of unintended consequences is still a "law" nonetheless. Ignorance, whether willful or not, does not absolve one from the effects of it.

So why do we need a European style labor regulation? We have choices, we have opportunity, and we have created an economy that produces more opportuntiy for those with ambition. Europe, by contrast, has limited choices for employment in good times, an extraordinarily high unemployment rate, minimal to limited opportunity until you're in your mid thirties, and a moribund economy.

Is all that really the model we want to be following?

Why The Bush Tax Cuts Weren't Enough

Last night I mentioned how the Bush tax cuts were almost certainly not the cause of the current bull market in stocks. In fact, the Bush tax cuts, while a nice and kind gesture, won't have their effects felt for years, possibly even well into the next decade. So if they weren't enough to have a real lasting effect on the stock market, what good were they and what would be needed to create that kind of effect?

What good were the tax cuts? Well, they were certainly better than a swift poke in the eye. And they did provide a short-term boost to the economy, in the form of the rebate checks, at a time when it was really on the verge of a demand collapse. In that sense, they were good and well-timed, plus anything that reduces the government's confiscation of resources is good in and of itself.

The biggest problem with the Bush tax cuts is that they were too little, too targeted, and too phased. In short, they were a half measure compromise.

In order to effect a real and lasting economic boost, there needs to be a fundamental and profound structural change in the tax system. The marginal rates need to be reduced across the board, and it needs to be a real and significant reduction, not just a token cut here or there. The long term capital gains rate needs to be significantly reduced. I don't agree with eliminating it completely, but for long term gains it should be small, on the order of 5 or 10%, not the current 20%. The tax on dividends needs to be eliminated, or if that is politically unpalatable, reduced to the long term capital gains rate.

Before I go further on some of the fundamental changes that need to be made, I want to explain the dividend rate cut in a little more depth. I had a long discussion with my father about this last night and I think that there were a number of important points as to why it would be wise to cut the dividend tax rate.

The theory of financial rationality tells us that a company should always look for the most efficient use of capital in order to maximize the return to the shareholders. Some years the company may have investment opportunities that would lead to them retaining more earnings than in other years, all depending on the expected rate of return for those retained earnings. If the expected internal rate of return is less than what the investor could expect to earn on their money in another investment, then the company should pay a dividend. If the expected rate of return is greater than what an investor could expect to earn in another investment then the company should retain those earnings, invest the money, and maximize the return to the shareholder through capital gains. In an efficient market, where companies are driven by strict financial rationality, dividend payments would fluctuate wildly from year to year or even quarter to quarter.

Obviously we don't function in a world driven by financial rationality. There are companies, like Coca-Cola, GE, GM, and Kellogg that like to maintain a constant, stable dividend payout as a shareholder service. They have made a conscious decision that stability is more important than absolute financial rationality - and this is not to be unexpected in a market where there is such stiff competition for investing dollars.

But the current tax system, which taxes dividends as ordinary income, adds a third level of complexity to the decision. Now companies no longer just take into account their financial needs when making their dividend/retained earnings decisions, they now also try to balance the tax burden that they are imposing on their shareholders.

Eventually, this leads to a situation like you currently have with Microsoft. Microsoft is no longer a growth company. It has become a mature, stable company, not unlike a GE or a Boeing. It has grown to a size where the internal rate of return on retained earnings is no longer significantly greater than what investors would earn in other investments. It has grown to a size where the law of large numbers indicates that the growth rate has to slow down. Even in the annual report the company is indicating that it is having trouble finding adequate investment opportunities for the cash on hand. This is why it is now hold cash measured in tens of billions of dollars.

Financial rationality says it is time for Microsoft to start paying a dividend. The structure of the tax system, and the burden a dividend would levy on the shareholders, says not to pay it (there is also the desire to maintain the perception of Microsoft as a growth company that is almost certainly playing into the decision also).

When the company sits on large piles of cash like that, it reduces the overall return on assets for the company. That in turn allows more suspect and questionable projects to proceed, as they appear to exceed the corporate return on assets. Over time, this would serve to further drag down to corporate return on assets, until a point is reached, where the expected return is essentially the same as the return the company can receive on cash. This appears to be where Microsoft is now.

Cutting the dividend tax rate would make companies much more likely to return some of the excess capital to the shareholders in the form of dividends. The money could then be reinvested more wisely and more efficiently, with the end effect of improving the state of the economy.

The other big tax that needs to be eliminated is the estate tax. All that it is is a tax on success. The elimination of the death tax, as the estate tax is often called, would obviate the current need for tax havens and tax dodges. The amount of wealth lost every year to this sort of legal tax evasion is staggering. And every bit of that money is wasted, not going back into productive use in the economy, which helps to hold us back. Bush realized this with his tax cut proposal, but it only eliminates the death tax in the tenth year of the plan - the final year unless Congress chooses to make the cuts permanent.

My purpose with this post isn't to denigrate what Bush has tried to do with his tax cuts. The idea and the reasoning for the plan was sound, it is only in the implementation that it loses effectiveness, and the implementation was watered down into little half-measures through politics and compromise.

As a result, the cuts had a temporary effect on the economy - which likely kept us from falling into to a depression induced by a drop in demand. Over the long term though, they will be of minimal consequence as they do little to nothing to change the structural disincentives of the existing tax structure. Only a true overhaul, no half measures, no compromise solutions, will truly create a tax system that works for us, instead of against us. And that in turn is why I personally favor (somewhat lukewarmly, granted) a move to a National Sales Tax.

The Bull Is Loose Again

While reading Michael Williams site Master of None, I came across this article from the Atlanta Constitution Journal celebrating the Bush Bull Market's first birthday.

It all sounds great and wonderful, right? Just one problem. Many of the historical comparisons are flat out false.

And if you've been out of the market over the last year -- tough. Consider what you missed:

As of Friday's close, the Dow Jones industrial average has risen 31.4 percent since Oct. 9, 2002.

The Standard & Poor's 500 index is up 32.6 percent.

And the technology-loaded Nasdaq composite index is up a stunning 68.8 percent.

Those gains rival historical norms (emphasis mine), including the robust annual growth rates of the 1990s market boom.

This is absolute, pure unadulterated bullshit. Those are not historical norms, they are a return to the unsustainable returns of the 1990s.

What are the normal numbers? Try this one for size:

Since the end of 1930 (we think it is appropriate to leave out 1929 and 1930), overall stock appreciation has averaged 8.8% a year. Total returns (appreciation plus dividends) have compounded at a rate of 11.5% (emphasis mine again) from 1931 to 1999.

Source: Financial Advisor Magazine

11.5%. That number jives pretty well with what is generally considered to be an aggressive equity based portfolio. In house research I've seen at now three different firms (two of them household names), plus research I personally did for one of my finance classes in college, indicate that the historical return for small cap stocks runs about 15%, for large cap stocks it's about 12%, so 11.5% isn't that far off from the numbers I'm accustomed to seeing. 30%+, that's not normal. That's a historical aberration.

For those who follow historical patterns, it's worth noting that the market started low and ended high in every decade (emphasis mine)since the 1930s.

Guess why they are using the decade time frame? Because that does not hold true over a five year span. But regardless, how relevant is it?

Again from Financial Advisor Magazine:

The very worst decade for total stock returns since 1930 was 1965-1974. The average annual total return for that awful period was 2.4%.

2.4%. Inflation generally runs higher than that. So while yes, the absolute dollar value of your investments would have risen over that decade time frame, the relative value would have declined. For perspective, according to the Department of Labor, Bureau of Labor Statistics, the cost of a $100 item in 1965 would have risen to $167.97 by the end of 1974, a 67.97% increase. By contrast, your $100 in an investment account would have gone from $100 in 1965 to $126.77 in 1974. In other words, your account went up, but you lost purchasing power. Ah the joys of inflation.

And here, I believe, is the truest reason for the bull market:

Still, after more than three brutal years, investors are more than a little gun-shy going into the final quarter of 2003.

This uncertainty is reflected in the decline in trading volume this year, even in the rally since March. Third-quarter New York Stock Exchange trading volume was about 12 percent less than the year-ago level, and was generally flat for the Nasdaq market.

This is also the most worrisome aspect of this bull market. A key that market technicians look for as an indicator of weakness is a rise on declining volume. Often times, it is the signal heralding a reversal in the general price trend. Without volume, this becomes a speculative bull market, not one based on investing, which points to it being short in duration and wild in the ride.

I'm glad to see the market performing somewhat better than it has over the last three years. Bush certainly didn't do anything (or fail to do something) to create the economic situation we're in now, this is the Clinton economic legacy. Bush's tax cuts probably helped some, but they were certainly not enough to have created a true long term bull market - that would require a fundamental and immediate change in the tax structure, not a phased in grouping of watered down half-measures (not all Bush's fault and still better than no tax cuts). This is probably more a case of the market reverting towards the mean. Let me explain.

Most market watchers use moving averages to smooth out the ups and downs of the market to get a general feel for the trend in a particular stock or index. Well the moving average also works like a magnet for the security being measured. If the security diverges too far from the moving average, it will attempt to revert to the mean.

In the late 90s, we diverged too far to the upside, and the market reverted back towards the mean in the form of a vicious bear market. Now as the market is wont to do, it overreacted. So now we're seeing a positive reversion to the mean. Same concept, different side of the curve.

Here is the biggest problem I see with this bull market: 36.79.

That's the current price to earnings ratio of the S&P 500. Again, for perspective, that number generally runs from somewhere around 16-20. Which in turn would point to the market being overvalued still by a factor of 1.75 to 2.25. Now I don't see the market dropping much more from here due to psychological factors, but I can see it remaining stagnant for a few more years as the fundamentals catch up to the price levels.

Like I said, it's good to see a Bush Bull Market and I hope that it gives him a boost politically, but this is a case where you have to keep your politics from blinding you from your investment goals. This market has a number of areas for concern. Invest as wisely as you politick.

Is The Credit Bubble Beginning To Burst?

Fredrick Sheehan has an interesting article over at PrudentBear.com in which he asks (and answers to a degree) if the actions of the Federal Reserve are impoverishing the American people.

I'm not going to try to deconstruct his case as, while it is very dark in its outlook, I believe it has some merit. It may be a bit too pessimistic, but I can't say absolutely that it's wrong or going off in the wrong direction. I would recommend reading it and forming your own judgment about its validity.

I will say that his characterization of the average new bond investor as uninformed is absolutely accurate. In my post about the basics of bonds one topic I did not go into was how bond pricing is derived from the relation of perceived risk to interest rates. That is quite possibly the hardest part of bond investing to grasp - and is absolutely the most misunderstood part (I'll write a detailed post on bond pricing later tonight or tomorrow).

But if I've expressed concern in the past about the possibility that we may be heading towards a deflationary cycle, how could I possibly agree with the statement that it is being caused by the Fed printing too much money, as that would normally lead to inflationary pressures?

Eventually it will, but right now the hyperactive printing of money is leading to the current housing bubble we're seeing:

From the fall of 1997 to the fall of 2002, the average house price rose in the U.S. rose 42%. In New York City, they rose 67%; in Jersey City, 75%; in Boston, 69%, and in San Francisco, 88%.

Those are unsustainable price growth rates. Yet, there are lenders still making 125% loans based on the idea that housing prices are incapable of falling and that the inexorable rise in prices will protect their irrational lending practices.

The refinanced mortgage that squeezes an extra $30,000 of money is not a risk, because everyone knows that house prices always go up. If one were to point out that real estate prices have fallen 70% in Hong Kong since 1997 and by an equal percentage in Japan since 1991, the reply would be: "But, this is America."

As a result of these types of loans we've been keeping our economy afloat with a giant national credit binge. But what happens when the mortgage lenders become unwilling to lend any more? There is already some concern that this may be beginning to happen:

...mortgages are pre-paying so fast that bankers may be reluctant to make loans - Brian Wesbury, June 23rd Wall Street Journal editorial

Why would the lenders be reluctant to make new loans? They are beginning to believe that they will get more for their money tomorrow than they can today. As a result, they are willing to sit on it. This is deflation at its basic. There is no sense in spending a dollar on a 2% return today, when you can 2.1%, or more, tomorrow.

And as the access to easy money dries up, so will consumer spending. As consumer spending dries up so will the ability of companies, like GM in the article, to repay their debt obligations. As the bankruptcies mount, so will the real losses sustained by investors and the banks. This will painfully wipe out most of the money printing going on by today's Fed. In the end, we will end up in just about the same place as we were prior to the credit binge.

The problem is that the solvent banks and people who live on a cash basis, rather than in debt, will be sitting on a huge pile of cash when the economy does start to turn around, which will happen once the oversupply problems are worked out of the system. And just as the supply and demand equation comes back in balance, most all of that cash will be spent or lent. And as it chases around the limited supply of goods and services available at that point, we will be hit with some pretty severe inflationary pressures, which will serve to cause even more pain.

I think that we are going to suffer from this to one degree or another. Right now our economy is surviving going from bubble to bubble, but we're starting to run out of non-leveraged assets. Housing was one of the last. When the housing credit bubble bursts, I think it's over.

The lesson to take away from this is that, in the Nineties, when we said "this time is different," we were as wrong then as they were in early 1929. The marketplace still punishes excesses. This time is no different than any other.

During the Nineties we experienced a boom of incredible proportions. It's almost time to pay up. Hopefully we can still afford the bill.

Economic Apocalypse?

For a few months now, I've had periodic posts about the threat of deflation given our current economic environment. In Financial Sense Online today is an interesting editorial that makes a similar point, although in perhaps a more apocalyptic manner.

To truly understand the article requires getting past the political statements about recent and current leaders. The policies of GW Bush and Bill Clinton are still too recent (and too similar to those undertaken in the last 50 years) to have had a real effect on the economy.

Deflation is quite possibly the greatest threat facing us today and this article does nothing to inspire confidence in our ability to avoid such a calamity. A deflationary economic cycle could very well plunge us into an economic depression that would have the possibility of tearing apart the social fabric of our nation.

I still believe that our best move is to use depreciation of the dollar as a way of exporting the deflationary pressure - for now. However, if we do take this action, we need to use the time it buys us to try to restructure our economy in a way that helps us to possibly avoid deflation. Otherwise all we've done is to put off the day of our final reckoning.

We've had it too good for too long now and the bill is finally coming due. I think it's time for credit counseling on a national scale.

Taking Out The Trash

Robert Prather over at Insults Unpunished has a posting about replacing the current income tax code with a transaction tax.

I've mentioned before that I would really like to watch our current tax system go away. It has got to be one of the biggest messes every devised by man.

The transaction tax is an interesting and successful concept. The Europeans have been using it for years - they call it the VAT or Value Added Tax.

Now, for a moment, ignore the negative connotations of the European version of the VAT. The concept is brilliant. It is applied equally to everyone with their contributions based on their consumption of goods or use of services. And because it would tax all factors of production, it would be as close to fair as we could realistically get.

I just have one small problem with the transaction tax idea. It's the same one I have with the European VAT and the same one I have with the current withholding system in the US.

The true cost of the tax becomes hidden.

Think about it for a minute. Every time a transaction takes place, a little tax is taken. The seller is simply going to raise his prices just enough to offset the new cost. With each transaction that takes place, that passed on cost grows, but it becomes built into the price rather than added on afterwards. The actual cost of the tax becomes hidden.

And because it is hidden, people don't react the same to an increase in the rate. Why are US sales taxes generally capped at less than 10% while the VAT in Europe runs around 17%?

It's because in the US we see exactly how much we're paying in tax when we purchase an item. An increase in the sales tax rate translates directly into a larger number at the bottom of every receipt we get. Because we can see the cost to us of the tax, we are more likely to fight arbitrary increases.

In Europe, on the other hand, you don't really now how much of the price of an item is tax. Is it 17%, or was some part of the item taxed somewhere earlier in the production process which created a passed on cost? There's no breakdown on the price tag of the item telling you how much is actual cost and how much is VAT. You don't know. You're operating in the dark and it's hard to distinguish inflationary price increases from small tax increases.

It is this hiding of the actual impact of a tax that bugs me with the current withholding system. Many people don't realize that that line on their paycheck that says "federal tax withheld" represents their money, not the governments. I've heard too many people saying, "well, it's not my money anyways" That's not true. It is your money.

The first step in overhauling our tax system needs to be the elimination of the withholding system. Make people write a check to the Feds every April 15. That alone will almost certainly provide the necessary support among the people to make the change happen.

But then I would still favor a sales tax on consumption over a transaction tax because of its openness in the real cost. A NST would show on the bottom of each receipt, just like a State sales tax. And since it is only charged to the end user, you can feel very confident in knowing the real amount of tax you pay each and every time you pay it.

The transaction tax lacks that openness. That makes it much more susceptible to political manipulation.

Neither system is perfect, but they're both a damn site better than the current screwed up system.

Job Hunting

So I leave work early today to go over and look for a new job at a job fair downtown. The best phrase I can think of to describe it is: disappointing. The first one of these things I went to coming out a college a few years ago had a couple hundred companies (2 typed pages in magnifying glass size print). This one had 28. The entire exhibitor list, plus all of the local colleges, save UCF, was on one typed page that was in type big enough to be read by the nearly blind.

Not that the job market is bad around here. I just saw a middle age guy in a suit and carrying a resume (which tells me he has more than a "got out of high school alive" education) getting excited about a $7.65/hour part-time pool tech job with no benefits. But I have got to find something. The job I'm in now doesn't cut it in any way, shape, or form.

One of the jobs I did apply for was as an advertising account rep with the paper. So on the way home (I have to meet with the plumber this afternoon, so I made it a long one by going to the job fair), I indulged in a bit of solo role-playing. Don't ask me why, but for whatever reason, when I'm driving alone, I role play what conversations might go like and I start to work on overcoming various objections or problems before they ever come up.

So today, as I'm puttering along, I'm role-playing a conversation about advertising with a friend who owns a store locally. And as I'm going along, I start trying to pitch how the internet would work into a comprehensive sales plan and to make it understandable, for both good and bad points, to a small business owner who doesn't particularly care for technology.

And then it hits me.

When the internet first really hit the scene, people raved about how it was going to put traditional retailers out of business. Bricks were out; clicks were in. The came the dot bust and suddenly bricks were back and the internet was put back on the back burner.

But I think a lot of people, myself included (Yeah, I know. I'm late to the party again.), missed the true revolution the internet created. It wasn't on a macro, or enterprise, level. Instead, the revolution was on the level of the individual.

Most big companies survived the internet threat without a real problem. They were able to restructure and to counter the threat. They streamlined and went on with life.

But at the level of the individual, the internet took out whole swaths of the employment realm. The restructuring and streamlining of the big companies in response to the internet for the most part wiped out the middle management as we know it. The ability of email and multimedia to transmit vast quantities of manipulative data lets the higher ups create their own middle management reports in minutes.

The result is a very flat organization with lots of low wage people at the bottom and a few high wage people at the top with almost no one in between. Yet our colleges and universities business schools continue to train students to enter the workforce in a middle management capacity.

The end result is the chaos I witnessed today. Individuals have not adjusted to the new paradigm. Middle management, the "home" many were hoping to fit into in the workplace, doesn't really exist today. Companies are driven by the market to provide the same or better services at lower prices. At the same time, they're driving the market to demand those lower prices by really only hiring for the lower wage positions. The cycle of lower, lower, lower has begun.

Eventually, as companies readjust to the new quantity of information available, they will eventually grow back into needing the middle management types again. Until then, this is going to be a really tough job market for me.